Beyond Stop/go?: Explaining Australia's Long Boom

Abstract

The pattern of boom and bust that characterised the Australian economy from the early 1970s to the early 1990s currently seems to be a thing of the past as Australia enters its sixteenth year of uninterrupted expansion. The expansion has lasted twice as long as those of the 1970s and 1980s, which raises the question--why has it happened? One way of approaching this question is to identify the factors that previously precipitated major slumps or recessions. The major recessions of the mid 1970s, the early 1980s and the early 1990s, were induced by monetary policy and a determination by the Treasury and Reserve Bank to slow an overheated economy. The first two policy-induced recessions were aimed primarily at fighting inflation. The recession of the early 1990s was a product of policy attempts to slow the economy in the face of a perceived current account crisis and domestic financial overheating, particularly the credit-fuelled asset price inflation of the late 1980s. The expansion that began in the early 1990s has also been characterised by large current account deficits and strong asset price inflation, particularly in the period since 2000. However, the policy response has not been sufficiently restrictive to generate a recession or even a significant slowdown in rates of economic growth. This is partly the result of greater confidence on the part of the Reserve Bank of Australia that the threat of inflation is under control and partly the result of a broader change of thinking about current account imbalances, which developed in response to the perceived policy errors of the early 1990s. According to the contemporary, 'consenting adults' view, current account imbalances are viewed as market outcomes which will only be problematic if prudential regulation is inadequate. Thus, the current account is no longer a target of monetary policy. The question of whether large current account imbalances will eventually generate increased vulnerability to adverse shocks, or whether the growing volume and sophistication of capital markets has rendered such concerns obsolete is central in addressing the sustainability of the current expansion. It may also be argued that the Reserve Bank has been more skilful, or luckier, in the present cycle than it was in the past and also that it has made better judgements than other central banks facing similar fundamentals, such as the Reserve Bank of New Zealand. This argument obviously raises the question of whether such superior performance can be sustained. In this brief article, we will discuss some of the issues regarding the contribution of changes in monetary policy to the longevity of the current boom, and their implications for the sustainability of continued expansion. We begin with an overview of monetary policy and its relation to inflation since 1970. Next we discuss changing views of the current account and their implications. Finally, some concluding comments are offered. Inflation, Financial Overheating and Monetary Policy Figure 1 charts CPI inflation against short-term interest rates since 1970 and indicates that periods of high inflation in Australia have often been associated with the imposition of high short term interest rates. This pattern is particularly clear during the 1974-5 recession and again in the early 1980s recession. The relationship breaks down somewhat during the remainder of the 1980s because the interest rate spikes of 1986 and 1989 both occurred amidst only modest increases in headline inflation and amidst more or less persistent falls in underlying inflation. As argued below, the high interest rate response of the late 1980s was primarily intended to fight other problems, such as domestic financial overheating and current account problems. [FIGURE 1 OMITTED] Australia's inflation problem, especially during the 1970s and early 1980s, was largely driven by pressures from labor markets. …